Apologies for the delay in putting this post up but as they say, “better late than never!”
That would be my answer if someone asks me the one concept I came across the most as an aspiring trader trying to get a hang of the subject! (Which is right now!! 🙂 )
So, here I am, summing up my notes on the basics of TRENDS.
Please note that “Trends” is a broad topic in Technical Analysis. There are a large number of traders who have made millions out of the market by following the trends while managing their entry and exit.
So this post is just a beginning while I try to explore this area further in the next few posts.
Below is a list of resources I have referred to for this blog:
- As mentioned in the previous post, “Technical Analysis of the Financial Market” by John J Murphy is going to be my bible for most of the posts in the immediate future.
- A very useful link from the website www.stock-trading-infocentre.com. They have plenty of articles around the technical analysis, which I will be exploring soon.
- A lot of different YouTube videos, which in essence simplified explanations. Just go through the first two search pages of YouTube with the keyword “Stock Market Trends” if you want to explore further.
- Charts from www.investing.com, which is an amazing free platform for someone to explore different indices and scripts across the globe
What is a trend in the stock market?
A trend in the stock market is defined as the general direction in which a market or a particular stock is moving.
It is decided by the equation between supply and demand, which is in a constant tug of war for greater control. Depending on who gains the command, a stock moves in an uptrend, downtrend or a sideways/horizontal trends.
An uptrend is when the stock is bullish with the price on a consistent increase. This is when the demand for a stock is considerably more than the supply for the same. An uptrend is characterized by:
Higher Highs – When the current high point of stock is above the previous high point, the stock is said to have formed a higher high. In the below chart, H3 is the current price, which is above the previous high of H2. Similarly, a higher high was formed between H1 and H2 as well.
Higher Lows – When the current low point of a stock is above the previous low, the stock is said to have formed a higher low. In the below chart, L3 is the current low point, which is above L2, creating a higher low. Similarly, a higher low was formed between L1 and L2 as well.
“Consecutive Higher Highs and Higher Lows is a very good indicator of the stock being in a continuous uptrend. “
A downtrend is when the stock is bearish with the price on a consistent decrease. It is when the demand for a stock is considerably less than the supply for the same. A downtrend is characterized by:
Lower Highs – When the current high point of a stock is below the previous high point, the stock is said to have formed a lower high. In the below chart, H3 is the current price, which is below the previous high of H2. Similarly, a lower high was formed between H1 and H2 as well.
Lower Lows – When the current low point of a stock is below the previous low, the stock is said to have formed a lower low. In the below chart, L3 is the current low point, which is below L2, creating a lower low. Similarly, a lower low was formed between L1 and L2 as well.
“Consecutive Lower Highs and Lower Lows is a very good indicator of the stock being in a continuous downtrend. “
Sideways or Horizontal Trend
A horizontal or sideways trend is when the trend doesn’t fall under either of the above variations. Here the supply and demand are nearly equal, and the price keeps oscillating in a channel.
You can see that the trend is not in one direction. It keeps oscillating, resulting in unpredictable price movement.
So how exactly does trends work?
Beginning of a trend is usually triggered by some fundamental or economic factor such as earnings or merger or new government reforms or regulation etc.
However, to a trader, the cause in itself is irrelevant because of one of the underlying philosophy of technical analysis – “the market action discounts everything,” as explained in the previous post.
Yet, the crucial thing that we, as learners, need to be very clear is that the price of stock never moves in a single straight line.
Nicolas Darvas, in his book “How I Made $2 MN in the Stock Market,” compares the extension of an existing trend with the leap of a dancer. A dancer typically crouches a bit before leaping into the air through the power generated through his/her legs.
Stocks acts in a similar manner!
When in an uptrend, traders tend to take out profit at different price points, defined by various technical indicators. It creates a situation where the price moves against the uptrend, which is commonly known as a “Pullback.” In the uptrend chart depicted above, H1-L2 and H2-L3 are examples of a pullback when the market is bullish. In the downtrend chart, L1-H2 and L2-H3 are examples of a pullback when the market is bearish.
A pullback is a necessary evil for stock to continue in a strong uptrend. It gives new buyers an entry point. It also helps existing buyers with an opportunity to increase their position. All of this eventually helps the stock in pushing through the pullback with more power, leading to
A mirror image of the same situation happens in case of a downtrend. Upon a reasonable fall in price, newer buyers tend to enter the market trying to catch the bottom of the fall with the expectation that there will be a reversal. Existing novice traders add to the demand trying to increase their position size to offset the already incurred loss. It leads to a minor reversal at which point existing stockholders try to sell it off pushing the supply over demand.
Result is a further fall, extending the downtrend.
Things change up a bit in the case of sideways/horizontal trend. As mentioned earlier, the price forms a channel with the supply and demand on almost equal footing.
The upper limit of the channel symbolizes the maximum price a buyer is willing to pay, and the lower limit of the channel signifies the minimum amount at which a seller is willing to sell.
Price keeps on oscillating till the scales tilt in favor of either one of the forces, resulting in a breakout and subsequent formation of a fresh trend.
Though a trend based trader is advised to stay away from a horizontal market, there are many traders who wait for a sideways channel to take advantage of the oscillating price.
Why is the trend important?
Imagine you are swimming in the sea with a powerful tide. You have to swim towards safety and yet conserve your energy as running out of steam would mean certain death.
One of the sensible options is to swim with the tide. The tide can carry you in its direction and lend you the support you need. On the other hand, swimming against the tide would tire you down quickly.
We have to take a similar approach when it comes to stock trading!
Many people tend to jump behind a trend at different points, which makes it run longer. Hence, it is prudent to take a trade in the direction of the trade. It is adviced that the trade should also be in the course of the broader index which guides the market in which the stock is listed to give it the best possible chance of succeeding.
Below chart shows a comparison between Infosys and Nifty50 price movement over the past couple of years.
However, do remember that just the direction of the trend is not going to ensure profits. It is equally crucial to have the right entry and exit points while taking trade!
Stock trading isn’t a race to be right! It is not uncommon to see traders who make millions out of the market lose more trades than they win.
You may ask, how is that possible?
Math and logic say that you will make money when you take smaller loses and bigger winners from the market.
So, the objective of the trader should be to take steps that have a better probability of success while giving protection against possible loses.
Identifying and following the existing trend is one such step!
In my next post, I will go drill down further into trends covering a few other facets important for us to use the trend as a tool in our trading strategy.
So until then, Cheers